An ETF invests on the opposite side of the Street

Commentary: Contrarian Opportunities index holds mainstream appeal

By

JohnPrestbo

NEW YORK (MarketWatch) -- While actively managed exchange-traded funds are becoming more plentiful, indexed investors need not feel neglected. The adventurous among them can choose from a growing number of ETFs that track indexes designed to measure active strategies.

Some of these passively managed active strategies are pretty simple. For instance, the iShares Dow Jones Select Dividend ETF
DVY, -0.12%
and Wisdom Tree Total Dividend Fund
DTD, -0.01%
are based on indexes that select high-yielding stocks from companies unlikely to cut their dividends.

Other indexed strategies are more complex. The FTSE RAFI U.S. 1000 Portfolio
PRF, +0.02%
for example, tracks an index whose components are selected and weighted according to several "fundamental" factors such as sales, cash flow and dividends averaged over the past five years.

Now comes a new index -- and an ETF based on it -- to track the so-called contrarian investment strategy, of which there is no precise definition.

Some describe contrarian investing as buying "when there is blood in the streets" or "betting against the crowd." Contrarians buy when bad news dominates the market and bearish signals are rife. They sell in times of good news and rampant bullish signals.

Searching for flaws

This is not simply a case of thumbing their noses at conventional wisdom. As we will see, the "contras" dig deep for evidence that the market has flubbed the pricing of some stocks.

How does the Dow Jones U.S. Contrarian Opportunities Index measure such a strategy that seems to require considerable judgment, a.k.a. "active" portfolio management? The answer illustrates the process of building a rules-based index methodology.

There is a practical reason to delve into these details. The JETS Contrarian Opportunities Index Fund
JCO, +0.63%
began trading on the New York Stock Exchange on April 9. Since the previous day's close, the U.S. market (as measured by the Dow Jones U.S. Total Stock Market Index) is up 3.1% through April 23, while the Contrarian ETF is up 4.7%.

The first step in index construction is to identify the market, or part of a market, to track. In this case, we began with the top 2,500 U.S. stocks by float-adjusted market capitalization -- essentially, large and small stocks but not micro-caps.

Next, the stocks are sorted in descending order of total returns (market action plus dividends, if any) for the preceding three years. At the most recent review in late January, the annualized returns ranged from a gain of 88.8% to a loss of 79.8%. Dividing the list in half, we discarded the 1,250 stocks with the best returns -- everything above negative 5.08% -- and lopped off the smallest 5% (62 stocks) to minimize liquidity issues.

Dogs that hunt

What is left is a "selection universe" of relatively out-of-favor stocks. This is the contrarian investor's hunting ground.

Of course, many of those stocks are in the dog house for good reasons, such as declining earnings, competitive weakness and other maladies. For our index, we wanted performance-lagging stocks of companies with solid fundamentals, which would rise even if all they did was revert to average performance. In addition, we looked for some indication that investors are beginning to appreciate those qualities and have begun nibbling at the shares.

To find them, each stock is ranked separately by 10 factors. Some of these factors are common sense, such as five-year sales growth (the higher the better); the price-earnings ratio (the lower the better), and the simple average of analysts' estimates of future five-year growth in earnings per share (higher is better).

Another one, intended to identify stocks in which investors are gaining interest, is total return for the preceding six months (the higher the better). The stocks we want are those beaten down over the past three years but showing recent signs of life.

Other factors are a more esoteric, such as the quotient of dividing the current price-to-cash-flow ratio by the company's median P/CF over the past five years (lower is better to identify "value"). And another: dividing "enterprise value" -- stock market capitalization plus the sum of debt and preferred stock minus cash and cash equivalents -- by earnings before taxes, interest, taxes, depreciation and amortization (EBITDA). Here, too, lower is better, just like with price-earnings.

The other four factors include: current price-to-free-cash-flow ratio, "free" meaning cash flow minus capital spending and dividends (lower is better); the change in cash flow in the preceding quarter (higher is better); and earnings-per-share revisions by securities analysts for the current quarter and the next quarter (rising is better than falling).

Each stock's rank for these factors is added up, and all together they are sorted in descending order of rank. The 125 stocks -- 10% -- with the best rankings are chosen for the index. However, at each semiannual review current components enjoy a 40% "buffer," which means they can sink as low as 175 in overall ranking and still remain in the index.

This rule mitigates component turnover and therefore the trading costs of a fund tracking the index. By its very nature, the DJ Contrarian Opportunities Index has high turnover. Historically, about 40% of components are replaced at each semiannual review, but turnover has been as much as 72% and as little as 25%.

Index components are equally weighted, which means that market moves by smaller stocks count as much as those of larger stocks. Thus, the smallest stock currently in the index, Anaren Inc.
ANEN
with a market capitalization of $191.5 million, started out weighing the same (0.8%) as the largest, Comcast Corp.
CMCSA, -0.26%
with a value of $44.5 billion.

High performance

This methodology has produced an index with rip-roaring performance -- up 10.4% in the first quarter versus 8.9% for the Russell 2000 Index
RUT, +0.34%
and 6.1% for the Dow Jones U.S. Broad Market Index, which consists of the 2,500 stocks from which the contrarians are picked.

The three-year annualized performance is even better: The Contrarian Opportunities Index had a positive return of 5.4%, while the Russell 2000 lost 4% and the broad U.S. market index sagged 3.7%. In gloomy 2008, the Contrarian Opportunities Index fell 31.3%, slightly less than the Dow Jones Industrial Average's
DJIA, -0.05%
loss of 31.9%.

By comparison, two contrarian-style mutual funds have not done as well. Fidelity Contrafund
FCNTX, -1.31%
was up 3.4% in the first quarter and posted a three-year annualized return of minus 2.7%. Dodge & Cox Stock Fund
DODGX, -0.10%
gained 6.3% in the first quarter and lost 12.8% annualized over the past three years.

But the DJ Contrarian Opportunities Index also is more volatile. Its returns varied 34.4% from average in 2009, more than twice as much as Fidelity Contrafund (16.9%); the Dodge & Cox fund had a dizzying volatility of 27.7%.

Historically the DJ Contrarian Opportunities Index's returns vary 18.3% from average on an annualized basis, which is less than the Russell 2000 (19.2%) but more than the DJ U.S. Growth Total Stock Market Index (18%).

Keep that volatility in mind if you take the new Javelin Contrarian Opportunities ETF out for a spin. My recommendation is to allocate no more than 10% to 15% of your equity portfolio to zigging while others are zagging.

John Prestbo is editor and executive director of Dow Jones Indexes, a joint venture of CME Group, Inc., and Dow Jones & Co., Inc., publisher of MarketWatch. Fernando Fernandes contributed research to this report.

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